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December 3, 2012

Where to Invest if Rates Rise—Searching for Alpha for December 2012

One of questions I'm asked most often is the potential impact of higher interest rates on portfolio returns. Investors seem aware that rates are extremely low—and artificially so, give the Fed’s easy money policy—but that they may return to historic norms.

The catalyst for higher rates could have economic or market-based origins. Stronger economic growth might cause the Federal Reserve to rethink its dovish mindset and put the brakes on asset purchases, which could potentially cause higher short-term rates. Or market participants might start selling Treasury debt for the potential for higher returns in equities. Either scenario could lead to higher rates.

The purpose of this memo is to identify the potential portfolio changes we may initiate if rates appear to be heading higher. Our methodology includes defining raising rate and falling rate periods; measuring the performance of a number of asset classes for each period; and analyzing the results.

High Rates, Low Rates

Perhaps the most straightforward definition of rising and falling rate periods is the concept of a “rate regime”:

A rising (falling) rate regime consists of any period over which the most recent rate action on the Fed Funds target rate was an om (decrease).

Since the Federal Reserve only changes its target rate on a periodic basis and because Fed Funds rate changes tend to occur in series of multiple increases or decreases, these “regimes” can often last months or even years (click on chart below to enlarge).

Source: Bloomberg

The next step in the analysis is to determine the performance for various asset classes during rising and falling interest rate regimes. The table below illustrates the results for eight different investments (click on chart below to enlarge).

Source: Bloomberg

As the table above shows, the return for stocks during periods of rising rates is similar to periods of falling rates. This is due to many factors, including the increasing latitude many companies have in raising the price of goods sold as rates increase. If rates were to rise, our portfolios would likely be redirected toward growth stocks, which tend to increase more than their value-oriented counterparts during periods of increased economic growth accompanied by rising rates.

The column titled “fixed income” above connotes the return of the Barclay’s Aggregate Bond index, the benchmark we use for fixed income positions, while the column “Treasury bonds” represents the returns for longer-dated U.S. Treasury securities. The performances from both investments tend to suffer with rising rate regimes. It is likely that we would transition portfolios to more dividend stocks to maintain the income generation of our portfolios during rising rates, as well as reducing the maturity of our bond holdings to protect principal.

Both managed futures and long-only commodity investments perform better as rates rise, since the prices of many raw materials tend to increase with inflation. These investments have provided valuable diversification during these periods, and I anticipate that we would maintain (or potentially increase) our positions during a rising rate regime.

Real estate investment trusts (REITs), which we have owned for much of the last 10 years in differing percentages, are mainly income-oriented investments and as shown above are less beneficial to own during rising rates. Although we might keep a small allocation to this asset class during a rising rate regime, our overall exposure would likely be reduced dramatically during such periods.

Finally, the chart above shows the returns of convertible bonds, which are fixed income securities that can be converted to stock under certain circumstances. Convertibles are sometimes referred to as “hybrid” securities, since they share characteristics of both equity and fixed income asset classes. This is an example of the type of investment we might add to our portfolios during a rising rates regime.

Perhaps the most important thing to note from is how proper diversification can prevent the increased volatility commonly associated with rising rates. We remain committed to transitioning client portfolios as conditions warrant, and remain vigilant in our pursuit of delivering the exceptional returns while keeping portfolio volatility and our sensitivity to market dislocations as low as possible.

If you have any questions, please feel free to call or email me at ben@qesinvest.com.

This document is for informational purposes only. This document may not be published or distributed without the express written consent of Quantitative Equity Strategies, LLC (“QES”) and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product.

The source of performance returns for all tables and charts in this commentary is Bloomberg, L.P and Bank of America Merrill Lynch.

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